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Are You Missing Out on Big Gains?

Mutual funds and volatility don't mix.

For decades, mutual funds have helped ordinary investors with modest sums of money buy diversified portfolios of stocks. Yet, while funds will always have a place in many portfolios, they aren't the best way to take advantage of the opportunities we're seeing now in the markets.

Instead, exchange-traded funds have shown their colors during the financial crisis. The current panic has made the advantages that ETFs have quite clear.

The ETF advantageThere's no denying that mutual funds provide a useful tool, especially to small investors. Before the advent of deep discount brokers, funds were the only economical way to get exposure to more than a few different stocks. Even load funds could prove cheaper than trying to pay high brokerage commissions on individual stocks.

Expenses. Although typical actively traded mutual funds often charge expenses of 1% or more annually, you can find many ETFs charging 0.25% or less. That may not seem like a big difference -- but over the years, even that small advantage adds up to big money.

Flexibility. Despite there being thousands of mutual funds, it's hard to find funds that will give you the exact investments you want. For instance, if you want exposure to solar energy, a fund like Fidelity Select Energy (FSENX) will give you stocks like First Solar(NASDAQ:FSLR) and Suntech Power(NYSE:STP) -- but you'll also get traditional energy stocks like Valero Energy(NYSE:VLO) and Halliburton(NYSE:HAL) that you might not want. ETFs, on the other hand, give you the full range, from broad-market investments in thousands of companies to highly focused bets on particular sectors -- including solar energy.

Timing. Mutual funds give you the end-of-day price. ETFs trade all day long, meaning you don't have to wait until 4 p.m. to see what price you'll get.

Let's take a closer look at this last point, which has been so important in recent weeks.

Buy when you wantMany people believe the biggest advantage of ETFs is that you can trade them anytime during market hours. Most of the time, that's more important for frequent traders than for long-term investors -- if you're planning to hold on to shares for 10 years, then paying an extra $0.10 or $0.20 per share isn't likely to make a huge difference.

But at least at the moment, having to wait until the market closes to lock in your trade price is a huge disadvantage. With the volatility we're seeing now, the Dow can easily moves hundreds of points between when you enter your order and the end of trading -- turning what looked to be a great opportunity into one that's not nearly as desirable.

One volatile dayAs an example, consider yesterday. Around 11 a.m., stocks were trading flat, having given up a decent rise at the open. The Dow was around 8,200. With an ETF, you could have bought shares then -- and locked in at those levels.

If you bought a mutual fund, however, you had to wait until the close to find out how much you'd have to pay. By then, the Dow was nearly 900 points higher. And look at how much more expensive some of Dow's components were by then:

Stock

11 a.m. Price

Closing Price

Boeing(NYSE:BA)

44.18

48.91

Verizon(NYSE:VZ)

28.46

31.65

Home Depot(NYSE:HD)

18.76

21.57

Source: Yahoo Finance.

On average, you would have paid 12% more for those stocks if you had to wait until the close of trading to buy, versus being able to buy at the low. And while market timing isn't a successful strategy, setting lowball price targets that may only trigger on an intraday basis is a great way to make money -- but one that most mutual funds won't let you do.

As long as the current volatility continues, ETFs will have a big advantage over traditional mutual funds -- and more investors will move toward ETF investing. Given how little difference active management has made for fund investors, perhaps that's a trend that's long overdue.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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